What Does a Divided US Congress Mean for the Economy and Markets? - Context

What Does a Divided US Congress Mean for the Economy and Markets? - Context

Democrats took the House of Representatives. Republicans held the Senate. What should investors expect from the US midterm election outcome? In the way of policy, not much. But the new political landscape may be good for markets.

The US midterm election result was in line with preelection polls and isn’t likely to change the outlook for the economy. With Congress split between the two major political parties, we think it’s unlikely that major new legislation will find its way to President Donald Trump’s desk before the 2020 presidential election.

For example, Democratic control of the House effectively dashes any chance of a second round of tax cuts—a scenario that could temper the upside potential for US equities. But with Republicans holding the Senate and the presidency, there’s little chance that Congress will be able to roll back recent changes and raise tax rates, either.

Democrats may decide to promote infrastructure spending, an initiative that Trump once also cited as a priority, but it’s not clear that Democrats and Trump will be able to work together. It’s also uncertain there will be bipartisan appetite for another burst of fiscal stimulus so soon after a 2018 tax reform package that’s estimated to add some $1.5 trillion to the budget deficit by 2027.

Markets sent a similar signal after the results rolled in. Global stocks and other risk assets got a boost while US Treasury yields fell modestly, suggesting that traders and investors were happy with a dose of predictability after several years of unexpected election results and developments around the globe.

Within equities, healthcare may benefit from a divided government, which would be unlikely to make major changes to the Affordable Care Act or drug pricing. And static fiscal policy should relieve a source of upward pressure on long-term US Treasury yields—but shouldn’t be a major headwind for credit assets.

Fed Expected to Stay On Course

One thing that won’t change with the shifting political winds in Washington is US monetary policy.

The Federal Reserve made it clear before the election that the US economy is strong enough to warrant additional rate hikes well into 2019. We still expect the Fed to deliver another 25-basis-point increase in December and four more hikes next year.

That will present some challenges for asset markets. But continued Fed transparency about its intentions should help to temper overall market turbulence.

Trade Tensions Will Persist

None of this means markets are entering a period of tranquility. The sharp ups and downs we’ve seen over the past few months will likely continue in 2019.

One reason: trade tensions are likely to persist. For one thing, the US congressional election result won’t have much effect on Trump’s trade policies. This is because Congress has over the years delegated much of its trade authority to the executive branch. If the US and China were to reach a deal to end their trade dispute, Congress would be required to vote on it. But in the absence of a formal agreement, trade policy is up to the President.

The trade standoff between the US and China may deepen a Chinese slowdown. And it could be an even bigger threat to growth in countries caught in the middle—those that depend more heavily on trade than either Washington or Beijing. What’s more, tariffs could increase the upward pressure on inflation in 2019.

Stay Active...And Don’t Sleep on Volatility

In the US, legislative deadlines loom for decisions on government spending and the debt limit. We expect Congress to meet those deadlines over the next few months and avoid a government shutdown. But market volatility could rise as the deadlines near.

And of course, the political cycle won’t stop spinning. Once the dust from the midterm election settles, attention will turn to the 2020 presidential election. With several sitting Democratic senators likely to throw their hats in the ring, expect more political posturing in Washington. As long as the economy holds up, markets should be able to withstand periodic bouts of turbulence. But politics remain an obvious risk factor.

We still believe—as we did before the elections—that market returns are likely to be lower in the years ahead.

That’s why we think it’s so important to embrace high-conviction insights and an active approach to portfolio management that incorporates political risk and the potential for policy changes into every investment decision.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.